Darling International (DAR)

Darling International is a rendering company. A rendering company is one where it goes around collecting oil, waste and other animal by-products from meat processors, bakeries, grocery stores, butcher shops and restaurants to recycle it into things such as pet food, soap and bio fuel.

Why is it Cheap?

Non-glamorous/dirty industry the business is in

Very old company. Over 100 years in the business.

Not cheap in my opinion

Only national publicly traded company in the rendering business. No comps and therefore lack of coverage despite being over $1b in market cap.

Management

Total executive compensation makes up 1% of revenue. Very good.

A lot of insiders selling recently at $14 – $15

Share count continues to increase. Lots of options to insiders. Not great.

Insider ownership is only 2.53%. Feel it is better not to buy when insiders are selling.

Growth

Can continue to grow by acquiring more contracts. There is a definite need for such a service and if DAR can efficiently expand its region, growth should come slowly and consistently.

Acquisition of Griffin added a new business segment

Growth could “possibly” could come from the joint venture with Valero in producing renewable diesel fuel but they are still several years away.

The industry itself isn’t hot or growing, therefore overall growth will be limited to territories.

Strategic Advantage

With the Griffin acquisition, it is now the biggest rendering company in the USA.

DAR may have economies of scale but can’t be too certain because operations involve capital intensive costs that can’t be lowered even with big scale operations. You still need to go out to each store, factory or restaurant to collect the waste. There will always be fuel, labor and truck maintenance cost involved.

Not a lot of competition due to nature of the industry. Not many entrepreneurs willing to start up a rendering company. No VC will fund them.

Competitors

No comparable comp on the public market

Final products compete with other commodities primarily corn, soybean oil and soybean meal. DAR’s product pricing depends on how these commodities are priced. If corn prices go down, they have to lower their price to compete. Riskiest part of their business as it is completely out of their control.

Risks

Pricing pressure as mentioned above.

Is the acquisition worth the price paid?

Can DAR consolidate the acquisition properly?

Relies on macro factors more than I thought. Such as commodity prices, energy prices because DAR uses a lot of natural gas to run boilers.

“operating performance was challenged by extreme summer temperatures in the Midwest”. Is temperature a risk?

A lot of FDA issues could arise based on how the animal feed is produced

Fair amount of off balance sheet liabilities

Underfunded pension plan + accrued liabilities

“As of October 1, 2011, the Company has an accrued liability of approximately $1.0 million representing the present value of scheduled withdrawal liability payments under this multiemployer plan”

Off balance sheet liabilities

Here are some sections from the 10-Q, 10-K.

“Company has commitments to purchase $27.8 million of commodity products consisting of approximately $19.9 million of finished products and approximately $7.9 million of natural gas and diesel fuel during the next twelve months, which are not included in liabilities on the Company’s balance sheet at October 1, 2011.”

“Company has committed to contribute approximately $93.2 million of the estimated aggregate costs for completion of the Facility in joint venture. Also has to pay 50% of everything overbudget.”

Expects to pay approximately $14.4 million in operating lease obligations during the next twelve months.

Total: $163m+ off balance sheet liabilities

Valuation

Acquisition in Dec 2010 so prior numbers do not have the new revenue included.

Looking at historical figures, DAR is not cheap at the moment.

P/B in the 2.5 ~ 3 range

P/FCF is greater than 20

ROIC is average 11% over 10 years

ROE average 18% over 10 years

Balance sheet shows company to be capital intensive

Debt from acquisition has been aggressively paid off but still remains

Even assuming that DAR makes $100m in FCF, a discount rate of 15% gives a market implied growth rate of 17%. Too high.

Based on last years EPS of $0.53, market implied growth is 20% using graham formula. EPS of $0.70 gives implied growth of 13%. Still too high.

If I adjust numbers to include the acquisition and what I “think” it will be, reverse DCF gives growth rate of 10% and reverse Graham gives 5%. Debt is at 8% interest so their growth should be higher than this to cover leverage costs.

Joint venture works out quicker than planned. (Don’t expect it though. Likely take minimum 3-5 years before anything happens.)

Conclusion

A dirty business off the radar on wall street. Business model is the type that value investors will enjoy, but whether management acts for shareholders is a concern. High capital business makes for slow growth in a slow industry.

Decent company overall but too much risk in the current stock price considering the growth expectations. Could easily keep running up as the acquisition proves to work itself out. If it drops to $10, then buy.

The Timken Company (TKR)

The Timken Company (Timken) is an industrial company that makes and sells products for friction management and power transmission, alloy steels and steel components.

Why is it Cheap?

In my opinion, TKR is only cheap if it can continue to meet expectations in growth and performance. If not, it could very well be expensive.

TKR hasn’t suffered a big catastrophe to make it cheap so for the time being, I’ll just consider it as a possibly inefficient stock price.

Management

Total insider ownership is 10% of the company.

The Timken family owns 10.4% of stock.

Total exec compensation is 0.5% of total revenue from 2010. Larger companies have smaller % as it should be. For a company this size, if insider compensation came out to be greater than 2%, I would be very worried.

Management seems to rarely buy any shares on the open market. Plenty of option exercises.

These businesses in boring industries that make acquisitions have tended to do well though.

Made 2 acquisitions in 2011 which added to EPS. Underlying original business is essentially flat otherwise.

Capex is expected to increase to $200m in 2011 vs $110m in 2010.

Strategic Advantage / Moat

Seeing as how their main option is to grow through acquisitions, I don’t see much of a moat or strategic advantage other than trying to buy out smaller competitors.

Business in general has low margins which doesn’t indicate much of an obvious advantage.

Competitors

One of the bigger players in the market.

Industrial industry is very fragmented though. Lots of custom work required.

In this type of industry, most companies have enough business to get by.

Risks

Makes small equity investments which are pretty bad. Had to write down certain investments completely. Management ability not that great in my opinion .

Quite a lot of liability accruals built up. Could be used as a cookie jar if the liabilities never occur.

Workers are in a union.

Pension and other postretirement contributions is going to double vs 2010 from $230m to ~$420m. This could increase with each year.

Valuation

ROE if you exclude 2009 is 12%

ROIC and CROIC isn’t impressive historically. In the single digits. If a company is leveraged and is only making these types of returns, then it’s even worse. TKR is fairly leveraged with debt/total assets being 60%. LT debt is 19% of total assets as of 2010 annual report.

Asset turnover has decreased over past 2 years

Cash position has increased

FCF is expected to decrease considerably

If everything goes according to plan and the growth capex succeeds in increasing FCF to around $300m, then with 12% discount, implied growth expectation is approx 10%.

If FCF turns out to be $200m, then company has to grow at 15% to match current stock price. That is a 50% difference. The range is far too much, in other words, it is quite risky.

However, story is different with EPS because of the many acquisitions.

Using EPS of expected $4.60 forward earnings, the market is implying a growth of measly 2%.

With $3 EPS, implied growth is 7%.

Cash flow wise, valuation is around $25 ish.

Earnings valuation gives about $50 ish.

Catalysts

Company has a joint venture which could be blockbuster (I doubt it)

Acqusitions continue to add bursts of EPS that drive the stock up as it has recently

Conclusion

Big player in a fragmented industry buying small competitors for growth. Acquisitions are done strategically to fit certain niche markets for growth. Company overall isn’t the best. It has mediocre numbers and operations with low margins, low erratic cash flows and is very capital intensive. But acquisitions are adding to EPS which is boosting the stock price and makes it seems cheap.

Question is, can it be sustained? Margin for error is too small as the intrinsic value range is too wide based on small adjustments.

It’s either a hit or miss with TKR. 50-50 probabilities aren’t good enough in investing.

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